It can be difficult to decide where to allocate your funds when you want to both increase your investment portfolio and reduce your outstanding debt. The decision typically depends on the potential return of the investment compared to the interest rate paid on the debt.
For instance, if you are considering purchasing a bond with a 5% interest rate, paying off a mortgage with a 6% interest rate, or reducing credit card debt with a 12% interest rate, you should probably pay off your credit card debt. When analyzing the situation, look at after-tax, not pretax, rates. In this example, interest income from the corporate bond is subject to federal income taxes, the mortgage interest is tax deductible, and there is no tax deduction for the credit card interest. If you're in the 25% tax bracket, the 5% rate on the corporate bond will net 3.75% after taxes, the 6% mortgage costs 4.5% after taxes, and the 12% credit card debt costs 12% without an income tax deduction.
There are some situations, however, when you should consider other factors, including:
- When your employer matches your 401(k) contributions
Many employers match contributions to 401(k) plans, which is money you lose if you don't contribute. Those matching contributions can make a big difference when deciding whether to invest or pay off debt. For example, assume your employer matches 50% of contributions up to 6% of your salary. If you're earning $50,000, a 6% contribution equals $3,000, with a $1,500 matching contribution from your employer. Thus, you should typically take advantage of all matching contributions before using money to pay down debt.
- When you are paying down your mortgage rather than other debts
Often, there is psychological satisfaction in paying down your mortgage to build equity in your home. However, mortgage debt is usually the last debt that should be paid off, since interest rates are typically lower than other forms of debt and the interest payments are tax deductible. If you want to pay down debt, make a list of all your debts, the interest rates, and whether the interest is tax deductible. Start paying off the debt with the highest nondeductible interest rate. Once that debt is paid in full, move to the next highest interest rate.
- When you're using money from your retirement savings to pay off debt
Many 401(k) plans allow loans at relatively low interest rates. Thus, you may be tempted to take out a loan and use the proceeds to pay off your high interest rate credit card debt and auto loans. One of the dangers of this strategy is you'll start to regard your retirement savings as a piggy bank that can be dipped into whenever you need money. It's typically better to leave retirement savings alone so the money can compound for your retirement. Also, you don't want to take out a loan, pay off your credit cards, and then start running up balances on those cards again
It can be difficult to decide where to allocate your funds when you want to both increase your investment portfolio and reduce your outstanding debt. The decision typically depends on the potential return of the investment compared to the interest rate paid on the debt.
